"Refinance when rates drop 1%" is a popular rule of thumb. It exists because closing costs are real money, and a small rate cut on a small loan can take years to pay back. But the rule ignores the two things that decide the answer: how big your balance is and how long you will keep the new loan.
The same 1% on three loans
Each case below refinances from 7.25% to 6.25% (example rates) keeping the same 27 years left, with typical-looking closing costs you should replace with your Loan Estimate figures.
| Balance | Closing costs | Monthly savings | Break-even |
|---|---|---|---|
| $120,000 | $4,000 | $77.41 | 4 years 4 months |
| $300,000 | $6,000 | $193.54 | 2 years 8 months |
| $600,000 | $9,000 | $387.07 | 2 years |
The same 1% pays back in 2 years on the largest loan but takes 4 years 4 months on the smallest. On the $600,000 loan, even a half-point cut (7.25% to 6.75%) breaks even in 3 years 11 months.
A better rule
Add a margin for uncertainty — plans change — and check the lifetime cost too, because a lower payment from restarting a 30-year term can still mean more total interest.
What counts as closing costs
Use the total of lender fees, points, appraisal, title insurance and recording charges from the Loan Estimate. Prepaid interest and the money that seeds a new escrow account are not true costs of refinancing, because you would pay that interest and those taxes and premiums anyway, and the old escrow balance is refunded. Leaving them out gives a fairer break-even. If the lender offers a "no-cost" refinance, the costs are usually built into a higher rate; compare the monthly savings on that offer with a lower-rate offer that has costs.
Other reasons to refinance (or not)
- Dropping PMI once you have 20% equity, or moving from FHA to conventional to end mortgage insurance.
- Switching from an adjustable rate to a fixed rate before an adjustment.
- Shortening the term to pay off sooner — see 15 vs 30 years.
- Not worth it if you expect to move soon, or if the new loan adds years you do not want.
Run your own numbers in the refinance break-even calculator. If the lender offers a lower rate for points, test that trade in the points calculator.